Rising interest rates and your lifecycle fund

Lifecycle funds (also called target-date funds) offer a convenient, age-appropriate way for investors to save for their retirement. Such funds update their asset allocations over time, gradually growing more conservative and allocating less to equities and more to fixed-income investments as retirement draws closer. They remain one of the most popular options in retirement accounts, with 23% of TIAA-CREF participants invested in at least one lifecycle fund.

But if you are approaching retirement, with a substantial amount of your savings in a lifecycle fund allocated to bonds, you may be wondering how potential increases in interest rates could affect the value of your fixed-income holdings. Recent headlines have speculated about when the Federal Reserve may begin to “taper,” or slowly unwind, its quantitative easing (QE) bond purchases and other policies that have kept rates at or near historic lows. This is a concern for anyone with significant fixed-income investments, since this is the asset class most sensitive to interest-rate changes.

Although interest-rate risk is always a consideration in fixed-income investing, there are four factors that may help buffer the impact of a potential rate increase on your investment in lifecycle funds.

Article Highlights

If you are approaching retirement, a substantial amount of your savings in a target-date fund is allocated to bonds.

Since fixed income is the asset class most sensitive to interest-rate changes, news about potential increases in interest rates may be worrying, but there are four factors that can help buffer the impact.

First, remember that different bonds perform differently, and choose a lifecycle fund that is well-diversified in its fixed-income investments.

Second, consider that concerns about interest rates may be overstated.

Third, seek out a fund with a greater allocation to equities near retirement, which may be better-positioned for this environment.

Finally, look for lifecycle funds that have flexibility in their asset allocation to help weather different environments.

1. Different bonds perform differently.

Bonds’ sensitivity to interest-rate movements can differ substantially based on duration, credit quality, and type of security. For example, in 2009 interest rates increased sharply, with the yield on the bellwether 10-year Treasury note climbing from 2.46% to 3.85%. Longer-term, higher-rated bond sectors tended to underperform during this period, while shorter-term, lower-rated, and securitized assets outperformed. In some cases, the disparity in performance among categories was dramatic, underscoring the value of diversification.

Looking forward, investors should consider that the highest-quality securities may be especially hard-hit when the Fed begins to taper its bond purchases, but there may be an impact on other fixed-income sectors as well. It is important to seek out lifecycle funds that are well-diversified among fixed-income assets to mitigate the potential impact of interest-rate increases.

2. Concerns about interest rates may be overstated.

With the bellwether 10-year U.S. Treasury yield having already risen to multi-year highs in the second quarter of 2013, we believe a significant, sustained rate increase beyond these levels is unlikely. A further spike in rates would have adverse implications for the fledgling housing recovery, business spending, and U.S. dollar appreciation (as well as the resulting decline in exports). If these measures of recovery began to flag, the Fed would be likely to intervene with policies to keep further rate increases in check.

Even if rates do increase, our analysis shows that bond markets tend to be resilient, bouncing back from initial losses when rates rise. In fact, average annualized returns for medium-term U.S. government bonds have been positive for all rolling three-year periods since 1926.

Of course, there is no guarantee that fixed-income markets will repeat this pattern of short-term reversals in the next interest-rate cycle. The past may provide useful context but is not a predictor of future outcomes, as economic and market conditions are never identical. This caveat is especially relevant in the current environment, given the lack of historical precedent for the degree of market support that has been provided through the Fed’s QE programs, and uncertainty as to how credit markets may respond when this support is withdrawn.

But investors would be wise to think beyond short-term market volatility and not try to time investment decisions based on the rise and fall of interest rates. As life expectancy in the U.S. increases, even individuals approaching retirement age may have 20, 30 or even more years to invest and receive income. Over time, the risk of being underexposed to fixed income may outweigh the risk of being exposed to rising interest rates.

3. Lifecycle funds with a greater allocation to equities near retirement may be better-positioned for this environment.

People saving for retirement need to weigh the higher market risks that accompany growth investments, like equities, against the longevity risk associated with lower-return investments, like fixed income. TIAA-CREF balances these risks in its lifecycle funds by allocating a higher percentage of fund assets to equities than a typical lifecycle fund. Our funds have a 50/50 split between equities and fixed income at the target-retirement date, allowing investors to maintain exposure to stock markets for higher return potential.

Ten years after the target retirement date, the allocation is 60% fixed income and 40% equities—a notably higher allocation to equities than the 30% to 35% weighting used by most of our peers. This approach reflects our belief that we must prepare our participants for a potentially longer retirement period with the ability to draw down savings gradually. At the same time, these allocations position our funds well for a period of rising interest rates, during which fixed income would be expected to underperform equities.

4. Flexibility in asset allocation can help lifecycle funds weather different environments.

All investors encounter short- and intermediate-term market events during the decades in which they build their retirement portfolios. As a result, you may benefit from a lifecycle fund, like TIAA-CREF’s, that uses tactical positioning to adjust its asset allocations to address such events. For instance, with interest rates rising, fund managers may choose to allocate less to long-term fixed-income funds and more to shorter-duration funds, or even to allocate less to fixed income overall in favor of equities. Such tactical moves should be temporary, however, and made within well-defined parameters so as not to fundamentally alter the fund’s strategic allocations.

The right lifecycle fund is a smart choice

Although the prospect of higher interest rates in today’s environment is real, diversified fixed-income exposure in lifecycle funds remains a prudent strategic allocation. Investors should do their research to ensure their lifecycle fund has the ability to react to market events while staying on track to provide a secure retirement. Talk to your advisor about the best lifecycle fund to reach your retirement goals.

You should consider the investment objectives, risks, charges and expenses carefully before investing. Please call 877-518-9161 or log on to www.tiaa-cref.org for product and fund prospectuses that contain this and other information. Please read the prospectuses carefully before investing.

Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income.

Please note: the target date for Lifecycle Funds is the approximate date when investors plan to start withdrawing their money. The principal value of the fund(s) is not guaranteed at any time, including at the target date.

TIAA-CREF products may be subject to market and other risk factors. See the applicable product literature, or visit www.tiaa-cref.org for details.

You should consider the investment objectives, risks, charges and expenses carefully before investing. Please call 877-518-9161 or log on to www.tiaa-cref.org for product and fund prospectuses that contain this and other information. Please read the prospectuses carefully before investing.

Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income.

Please note: the target date for Lifecycle Funds is the approximate date when investors plan to start withdrawing their money. The principal value of the fund(s) is not guaranteed at any time, including at the target date.

TIAA-CREF products may be subject to market and other risk factors. See the applicable product literature, or visit www.tiaa-cref.org for details.